How to Beat the Investment Funds: Outshine Most Mutual Funds and Hedge Funds plus Earn a Bonus

If you’re like many investors, you must think that the title of this article is just a joke, and there’s no way for you to beat the full-time pros that run mutual funds and hedge funds. Or you might expect to read here that you should go back to school and earn a graduate degree in investment finance. Or maybe you ought to go out into the financial forum and spend a couple of decades learning the trade at the feet of renowned wizards in the marketplace.

If your thoughts ran along these lines, then you were mistaken. In reality, the title shown above is dead serious. Really it is.

There is actually a simple way to outshine the mass of mutual funds and hedge funds as well as private investors. The reason is that the objective is not daunting or even demanding.

Before we get down to brass tacks, though, we ought to spell out exactly what the goal is. Also, it’s helpful to get a good grasp of the nature of the competition. That way you’ll have a better appreciation for the what, why and how of the gambit for trumping the mass of players in the arena.

Getting a Fix on Mutual Funds

A raft of studies over the decades has shown that mutual funds as a group trail behind the stock market at large. Although the specific numbers may vary somewhat from one probe to another, a representative result is that the annual return from mutual funds is on average half percent lower than the benchmarks of the bourse.

One reason is that mutual funds have a habit of charging a maintenance fee based on the total value of the assets under management. In the past, the fee has ranged anywhere up to a couple of percent – or even higher – of the average value of the portfolio over the course of the year. In a hypothetical world, if the administrative load were waived, then the average fund might for the most part keep up with the market averages.

What can we infer from these observations? Based on the data, the pack of mutual funds as a whole adds no value to the task of picking stocks for investment. In spite of all their efforts to the contrary, professional managers as a group make moves that are equivalent to picking stocks at random.

Removing the Veil from Hedge Funds

In a raft of ways, the performance of hedge funds is even worse than that of mutual funds. According to impartial studies, the top tier of hedge funds ekes out a gross profit that is comparable to the average performance of mutual funds.

On the other hand, the net return to the investors is a lot less for a bunch of reasons. One big stumper lies in the practice of taking a big cut out of the profits.

The performance fee tends to range from 20 to 50 percent of the returns for any period in which the portfolio happens to turn in a profit. Due to the hefty bite, patrons end up with a significantly smaller piece of the pie.

On top of all this, the investors have to pay a fixed fee for administrative expenses regardless of performance. The usual charge comes out to a couple of percent each year of the total value of the assets under management.

The top cohort of hedge funds may be able to keep up with mutual funds in terms of gross returns, before taking out a big chunk of the pie for performance fees on top of the fixed fee for maintenance charges. However, this lackluster outcome only applies to the survivors in the marketplace.

Sadly, though, survival is an elusive goal in this domain. The situation is underscored by the most benign periods for hedge funds: the last portion of the 20th century.

Over the two decades ending in 2000, the S&P 500 index did not just double or quintuple; rather, the benchmark expanded by a factor of 12.2. Given that hedge funds are fond of leverage, they should have performed far better than the benchmark over the prosperous stretch.

In reality, however, the army of hedge funds was unable to do anything of the sort. On the contrary, the addiction to extreme amounts of leverage meant that the plungers went bankrupt in droves any time there was a dip in the marketplace.

As a result, roughly half of the top tier of hedge funds went out of business within 5 years after they entered the public limelight. As a rule, only half of the top tier of hedge funds breaks down within half a decade when the winds blow favorably. That is the good news.

During a cataclysm in the marketplace, however, the plungers have a way of going bust in droves. A case in point was the financial crisis of 2008, which stamped out hedge funds by the thousands in a snap. That is the bad news.

Either way, the investors get to lose their shirts en masse. The only real question is whether they get shorn of their attire in short order or even sooner.

Barren Decisions on Investment Funds

Amid the din and noise of the financial forum, the general public subscribes to a host of unproductive schemes. As an example, myriads of investors squander their money on mutual funds that levy a fixed fee of a couple of percent each year for holding onto their assets. By contrast, the gamesters could easily secure better results through cost-effective pools that charge a pittance for their services.

A second curio lies in the fact that so many investors hanker after hedge funds when they could do much better on average with other vehicles including even mutual funds. Apparently the clients are unable or unwilling to ferret out the facts needed to make a cogent decision.

A third stunner involves the fact that the average investor earns even less than the average mutual fund. The crux of the problem springs from the custom of giving in to excess through alternating bouts of mania followed by panic.

During the extreme stages of the market cycle, the punters load up on stocks precisely when they ought to selling, then dump their holdings exactly when they should be buying. The upshot of the ditsy practice is to give up the profits and lock in the losses.

A fourth irony is that investors as a group spend so much time and effort trying to beat the market but end up lagging the benchmarks by a hefty margin. The results could be much better if the gamesters were to take a simpler tack then ignore the market completely. In that case, the demure investors could for the most part stay abreast of the market averages without wasting any time on trading or putting up with the headache of thrashing prices.

In fact, the players could beat the market over the course of a price cycle if they were to use a technique known as dollar cost averaging. To add icing on the cake, the scheme can be set up easily then left alone to run on autopilot.

At this juncture, however, we should note that the goal of beating the market averages is a topic best left to a separate article. Getting back on track, our purpose here is to trump the average pool in the marketplace, whether in the form of a mutual fund or a hedge fund.

Paying Yourself a Bonus for Beating Your Rivals

If you can keep up with the stock market at large, then you are outpacing the average pool managed by professional caretakers. That outcome will also ensure that you beat out the mass of individual investors by a comfortable margin..

In fact, you could pay yourself a management fee of nearly half a percent a year on the total value of your portfolio. In that case, you would of course trail behind the market benchmarks by a similar amount. Even so, you would still beat the bulk of the competition in the form of mutual funds, hedge funds, and solitary investors.

So what’s the best way to achieve this exceptional feat? All you need to do is to take up the following procedure.

1. Setting up a Brokerage Account to Buy Stocks Online

As a prudent investor, you want to find a brokerage firm that charges you little or nothing for the privilege of handling your account. To begin with, you should seek out a broker that does not burden your account with some type of maintenance fee each year. Moreover, the firm would charge you little or nothing to buy or sell stocks.

2. Choosing a Suitable Yardstick for the Stock Market

What does it mean to “beat the market”? The first task is to define what you mean by the market. Your definition will determine the proper benchmark to gauge the performance of the bourse.

The best known yardstick in the marketplace is the Dow Jones Industrial Average. The drawback of this index is that it covers only 30 of the largest firms listed on the U.S. stock exchange.

Due to the narrow focus, the Dow is rarely the benchmark of choice for the large community of professionals working in the financial sector. The same is true of researchers engaged in rigorous studies of the marketplace.

Rather, the usual yardstick is a composite measure of 500 stocks compiled by the Standard & Poor’s division of the McGraw Hill publishing group. The benchmark, widely known as the S&P 500 index, is the most common proxy used by professionals as well as researchers.

Since your goal is to beat the professionals at their own game, the obvious choice of yardstick is the 500 index.

3. Picking a Low-Cost Vehicle to Track the Index

Your next task is to select a vehicle whose mission is to match the performance of the S&P 500 index. Moreover, the rig should be efficient enough so that the administrative burden on your portfolio will be negligible.

Although there are different kinds of index funds, a good choice for your purpose is a type of pool known as an exchange traded fund (ETF). For tracking the S&P 500 index, the standard bearer is the Standard & Poor's Depositary Receipt (SPDR). The index fund has an expense ratio of less than 0.1% of the total value of the assets under management.

4. Buying Shares of the Index Fund

The shares of an ETF may be bought and sold just like any other stock on the bourse. In other words, you can snag a stake in the SPDR for your stock account. The security trades in the United States under the ticker symbol SPY.

Due to the preceding pair of labels, the SPDR’s have given rise to a couple of nicknames. In particular, the terms Spiders and Spyders often crop up in the argot of the stock market.

5. Holding the Position for a Suitable Period

As an investor, your planning horizon could range anywhere from a few months to several decades. If history is any guide, you will end up outshining the vast majority of contenders in the stock market whether in the form of full-time pros or part-time amateurs.

Moreover, you can pay yourself a nice reward of half a percent each year from the total value of the portfolio. Even after you take out the bonus, your portfolio will still beat the managed funds as a group.

Moreover you will far outpace the average outturn of investors that trade for their own account. The same is true of the mass of customers of hedge funds who have to settle for the leftovers after paying off the performance fees to the operators in a profitable year; or absorbing the entire loss whenever the portfolio takes a dip or even blow up completely.

Better yet, you don’t have to do anything to earn the windfall at the end of each year. The stewards of the index fund are duty-bound to take whatever steps are required to keep up with the yardstick. An example of the latter is to adjust the portfolio when a flagging stock in the benchmark is weeded out and replaced by a rising star.

In the meantime, you can go on a permanent vacation and still earn your well-deserved bonus. Moreover, a stout fund which uses no leverage is likely to survive any disaster that the marketplace can throw at it.

In this sense, an index fund based on a sturdy benchmark is unlike flimsy vehicles in the form of individual stocks or wildcat pools. The frail rigs in the latter groups can and do go bankrupt in large numbers; all too often, they wipe out within a matter of years rather than decades.

By taking up an index fund that uses no leverage, you can enjoy the boons of the bourse and limit the banes while doing nothing further to earn your keep.

You can hardly ask for more from the stock market. And you would be hard-pressed to find a similar deal in any other area of life.

A Sprinkling of Tips and Caveats

You will find more information on the nature of hedge funds in a set of articles titled, Hedge Funds. The survey also talks about a number of related topics such as the underwhelming performance of mutual funds as well as individual investors. The link to the suite is provided in the Resources section below.

The aptness of mutual funds, hedge funds, and index funds for investors is examined in an article titled, “How to Compare Investment Funds by Type”. A link to the piece is given below.

You can find tips on finding an online broker an article called, “How to Pick the Best Broker to Buy Stocks Online”. The write-up is located at the address provided below.

For most investors, the toughest part of the procedure described in this article is also the simplest task: doing nothing. The urge to meddle with the portfolio by buying and selling at the worst possible stages is precisely the reason why the majority of private investors trail behind the market averages by a hefty margin. So you need to control your impulses and ignore all the hoopla, whether positive or negative, buzzing around the bourse at large.